Why is the Bank of Canada so fixated on a 1% rate?

Bank of Canada fixated on 1% interest rate, but why?

The Bank of Canada has held the benchmark interest rate at 1% for nearly three years running and despite record household debt, a crumbling eurozone and slowing growth in China, there’s still no sign that’s going to change any time soon.

The Bank of Canada is putting its stock in a modest recovery in the United States to lift exports and investment in this country, which itself will see slower growth this year than previously thought.

“Given the growth that we expect in the housing market in the United States, we see about 1% [additional annual export] growth in Canada,” Bank Governor Mark Carney said Wednesday. “That has a flow-through [effect] on exports.” Read more.

It’s not the lowest rate on record — for a stretch in 2009 and 2010 it went down to just 25 basis points — but it’s certainly one of the longest periods in history of the central bank that the overnight rate has been kept close to rock bottom for so long.

Interestingly, the Governor of the Bank of Canada has been hinting for more than a year that the next rate move will be up even as the outlook for economic growth has grown increasingly gloomy — leading some observers to predict that in fact a downward shift is more likely.

At 1% it’s still providing significant stimulus to the economy

According to Toronto-Dominion Bank chief economist Craig Alexander, there’s nothing inherently special about 1% other than the fact that it’s probably the best and most appropriate level for the benchmark, given the anemic domestic economy and the complicated global environment with still fast-growing China offsetting troubles in Europe and the U.S.

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Rock-bottom rates create a whole host of problems for financial institutions such as banks as they find themselves under pressure to pay interest on deposits. For insurance companies the stress can be even greater as they feel compelled to buy riskier investments to meet their policy liabilities.

“So it makes sense to get interest rates up off the floor,” he said

I think it’s a bit unrealistic to think that the Canadian economy will rebound to its potential

The challenge for Mr. Carney is that the economy seems trapped in a cycle of false starts followed by periods of decline.

Speaking to reporters in Ottawa on Wednesday, Mr. Carney acknowledged the Canadian economy has “material slack” though relative to other regions it’s “not that big.”

“We have a financial sector that is as resilient as any in the world,” Mr. Carney added.

But some observers suggest that’s just rhetoric. The domestic economy is worsening and it will likely continue to do so, said David Madani, Canada economist for Capital Economics.

“I think it’s a bit unrealistic to think that the Canadian economy will rebound to its potential,” he said, offering three reasons.

First, because of the increasingly fragile global economy, which is facing increasing headwinds from the eurozone crisis. Second, commodity prices have been slumping for some time and they continue to move down, including oil, which is especially damaging to this country’s prospects. And finally the housing market, a key driver, continues to soften, sparking fears of a major correction.

As it stands the consensus among economists for Canadian GDP growth is about 1.5% for this year “but I think you’ll see that shift lower over the next six months,” said Mr. Madani, who calling for expansion of 1%.

Given that outlook, he argues that despite the Bank of Canada’s tightening bias, the next interest rate move is most likely to be down. If growth starts to falter, it won’t have any choice but to try to chop the rate if it is to have any hope of bringing the economy back on track.

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